The ability of the insurance mechanism to respond to the challenges of natural disasters has become increasingly questionable as the values exposed to such events grow. Because people increasingly choose to live and work in catastrophe prone areas, values thus exposed grow more rapidly than values overall. The shortcomings of the insurance industry will therefore grow as time goes on. To date they have been most apparent in the wake of disasters like the Northridge earthquake (Jan. 17, 1994 in Los Angeles) and Hurricane Andrew (Aug. 24, 1992, in southern Florida).
Simply stated, the insurance industry, as it is currently configured, deals badly with certain concentrations of risk. There are commercial, financial, regulatory and tax considerations which play a role in the inability of the insurance community to absorb these risks adequately. However, the main bottleneck is reinsurance, the means by which catastrophe exposures supposedly ‘spread’. Reinsurance in fact has the opposite effect to that intended. Being a relatively small and arguably under-capitalized sector of the insurance industry, reinsurance depends on the appetite of its capital providers for volatility, and the use of reinsurance therefore has the effect of concentrating rather than spreading the risk. Following the strain of a major loss event, the price of reinsurance protection usually climbs sharply.
For example, in the case of the California Earthquake Authority, the chief provider of earthquake insurance for homeowners in California, the prices to be charged home owners for their coverage were initially calculated using the technical assessment of the susceptibility of properties in various parts of the state to loss as a result of earthquake. There was an additional provision made for the operating expenses. The CEA then determined the cost of the necessary reinsurance to protect their ability to respond to a loss. Because of the friction involved in concentrating earthquake exposure in the reinsurance community, the cost of purchasing reinsurance had the effect of virtually doubling the cost of coverage to consumers in certain very sensitive areas (according to a senior official in the Insurance Department at the time). This was because there was a “technical” price for the risk to be covered by reinsurers and a “commercial” price needed to convince reinsurers to take on yet more liability in a prospective event to which they were already heavily exposed. The difference between these two was large enough to double the cost to consumers.